Financial Industry Regulatory Authority (FINRA) Practice Exam

For subordinated debt, which statement is true?

1. A subordinated debenture has a claim that is junior to all other debt but senior to preferred stock

2. A subordinated debenture has a claim that is senior to all other debt issues and equity issues

3. A subordinated debenture has a claim that is senior to all other debt and senior to common stock

4. A subordinated debenture has a claim that is junior to all other debt issues

The correct answer is: A subordinated debenture has a claim that is junior to all other debt but senior to preferred stock

A subordinated debenture indeed has a claim that is junior to all other debt but senior to preferred stock. In the hierarchy of capital structure, subordinated debt is designed to offer a higher yield to compensate for the higher risk associated with its lower claim on assets in the event of liquidation. When a company faces insolvency, the claims against the company will be settled in a specific order: first, secured debt must be paid, followed by unsecured debt, and only after all senior creditors are satisfied will subordinated debt holders receive any payment. This means that subordinated debentures rank below other debts but above preferred stockholders when it comes to claims on the company’s assets. In this context, the other options mischaracterize the position of subordinated debt. There is no scenario where a subordinated debenture would hold a senior claim over all other debt issues or equity classes, such as common stock or even preferred stock, which is ranked above in terms of claims to company assets after all secured and unsecured debt obligations are fulfilled.